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Tuesday, June 30, 2009

Brad Delong is wondering whether the Federal Reserves' low interest rate policy in the early-to-mid 2000s was truly a mistake:

There is, however, active debate over whether there was a fourth mistake: whether Alan Greenspan's decision in 2001-2004 to push and keep nominal interest rates on Treasury securities very very low in order to try to keep the economy near full employment was a fourth mistake...I am genuinely not sure which side I come down on in this debate.

Brad's uncertainty is understandable given he invokes the entire 2001-2004 time frame. For during this period there was a time when the U.S. economic recovery was sputtering along (2001-2002) and a time when the recovery began to take hold (2003-2004). It was during this latter period that Fed's low interest rates were a big mistake. But even for that period I think Brad is misreading the data:

People claim that the Greenspan Federal Reserve "aggressively pushed the interest rate below its natural level."... [T]he market interest rate[, however,] was if anything above the natural interest rate in the early 2000s: not accelerating inflation but rather deflation threatened. The natural interest rate was very low because, as Ben Bernanke explained at the time, the world had a global savings glut (or, rather, a global investment deficiency). You can argue--and on Tuesdays and Thursdays I will believe you--that Alan Greenspan's policies in the early 2000s were wrong. But you cannot argue that he aggressively pushed the interest rate below its natural level. The low interest rate was at its natural level.

I think the evidence shows the opposite. The natural interest rate is a function of individual's time preferences, productivity, and the population growth rate. Of these three components, the one that changed the most in 2003-2004 was productivity as can be seen in the figure below (click on figure to enlarge):

Here we see productivity growth soaring just as the real federal funds rate is being pushed into negative territory. Normally, a rise in productivity growth should lead to a rise in the natural interest rate and ultimately, a rise in the federal funds rate for monetary policy to stay neutral. However, this latter development did not happen. It seems, then, the Fed did push its policy rate below the natural rate and in the process created a huge Wicksellian-type disequilibria. This interpretation of events has been borne out more rigorously in this ECB paper. One a more practical level, this disequilbria comes through in the Taylor rule which similarly shows the federal funds rate was below the neutral rate during this time.

It is also worth noting that these same rapid productivity gains were the source of the deflationary pressures in 2003 that Brad mentions. Thus, these deflationary pressures did not indicate a weakening economy. In fact, aggregated demand (AD) was growing at at rapid rate in 2003-2004 which, if anything, indicated an overheating economy. The figure below shows a measure of AD, final sales to domestic purchasers, relative to the federal funds rate and has the period 2003-2004 marked off by the dotted lines (click on picture to enlarge):

The productivity gains, apparently, were offsetting the upward pressure on prices being created by the robust growth in AD at this time. There simply was no real deflationary threat in 2003. By way of contrast, this figure shows for 2008-2009 what a real AD-induced deflationary threat looks like. Regarding the saving glut theory I would recommend Menzie Chinn's post here or my previous post here.

The final data issue is the weak employment growth coming out of the 2001 recession. Given the above discussion, the best interpretation of this development is there was less demand for labor in the recovery given the productivity gains. In fact, this was common explanation given at the time. One could also argue that the Fed's low interest rate policy may have pushed some firms to inordinately substitute out of labor to capital.

Here is the bottom line: there is enough evidence for Brad DeLong to conclude that Federal Reserve's low interest rate policy was a mistake.

Thursday, June 25, 2009

The Saving Glut theory of the buildup of global economic imbalances and its application to the current economic crisis has been a popular story ever since it was introduced by Ben Bernanke. Menzie Chinn, however, has dealt a serious critique to this view that probably will be followed by others as time goes on. His view is that the Saving Glut (1) should be put to rest as an idea, (2) is mostly a mirage of the data, and (3) did not cause the current economic crisis. I agree with most of what Chinn says in this critique. I would note, however, that some of the key problems with the Saving Glut theory occur because the role of U.S. monetary policy is not properly accounted for in the analysis. Here are the problems:

(1) The Saving Glut theory has an underlying theme of inevitability. The implicit message is that the U.S. was destined to be a profligate spender because of the huge CA surpluses in Asian and oil-exporting countries. Really? Were U.S. policymakers truly constrained by the whims of foreign savers?

A key reason why this inevitability view is suspect is that it ignores a key fact: the Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.

What is interesting is that many advocates of the saving glut view who argued the U.S. had to run a current account deficit in the early-to-mid 2000s to accommodate the current account surpluses elsewhere in the world later argued in the middle of 2008 that loose U.S. monetary policy was being exported abroad creating too much stimulus in the dollar bloc countries. In other words, these observers had somehow gone from a world where the Fed is a slave to the dollar block countries to a world where the dollar block countries are a slave to the Fed. For example, here is Martin Wolf who argued early on the inevitability of U.S. current account deficits but then had this to say in June 2008:

To simplify, Ben Bernanke is running the monetary policy of the People’s Bank of China. But the policy appropriate to the US is wildly inappropriate for China and indeed almost all the other countries tied together in the informal dollar zone or, as some economists call it, “Bretton Woods II”.

Thus, not only have the imbalances proved hugely destabilising in the past, but they are going to prove even more destabilising now that the US bubble has burst. When most emerging economies need much tighter monetary policy, they are forced to loosen still further.

To be fair, Martin Wolf has since come to acknowledge the U.S. monetary policy played a role. But the point is clear: if the Fed was a monetary hegemon in 2008 then it was also one in the early-to-mid 2000s. It could have tightened policy then and prevented some of the saving glut.

(2) Long-term interest rates were going down across the globe. The saving glut, however, was regionally based in Asian and oil-exporting countries and mostly went to a regionally-based saving deficit area, the United States. How, then, could a regional saving glut cause global long-term rates to decline? (This is why the saving glut explanation for the interest rate conundrum in 2005 is far from satisfactory.) An easier explanation is that Fed's low interest rates in the early-to-mid 2000s were exported across the global economy as described in (1) and transmitted to long-term rates via the expectation hypothesis of the term structure of interest rates.

(3) If the huge CA surpluses in Asian and oil-exporting countries did, in fact, lead to the lowering of long-term rates in the U.S., which in turn fueled the housing boom, why did long-term rates start rising in 2006? How is that the saving glut could fuel low rates in the early-to-mid 2000s but not thereafter? See the figure below (click on figure to enlarge):

(4) Finally, close to 40% of mortgages issued at the height of the housing boom were either subprime or Alt-A. Unlike traditional long-term, fixed-rate mortgages these other type of mortgages had financing charges tied to short-term interest rates . The Fed controls short-term interest rates. The saving glut story typically focuses on the long-term rates. As Larry White notes, the Fed's policies clearly were the big factor here.

To be clear, I do believe this crisis was more than just poor choices made by U.S. policymakers. The securitization of finance, underestimating aggregate risk, the lowering of lending standards, rating agencies failing, aggressive lending tactics, and poor choices made by lenders all contributed to the current economic crisis. However, the Fed's monetary policy choices in the early-to-mid 2000s was in my view key to making these other developments more distortionary and its role helps shed light on the problems with Saving Glut view.

Tuesday, June 23, 2009

The Economist's magazine is reporting on how the recession is affecting church attendance and more-or-less concludes there is no evidence of a link. The article, however, has a number of problems. Let me begin with this paragraph:

Last year David Beckworth, an assistant professor of Economics at Texas State University, examined historic patterns in the size of evangelical congregations and found that, during each recession cycle between 1968 and 2004, membership of evangelical churches jumped by 50%. This report filled the newspapers and TV news-shows at the height of the depression panic just before Christmas; but the report’s findings focused on evangelicals, and do not apply to Americans at large.

I did not find membership jumps by 50% during recessions, rather the membership growth rate jumps by that amount. Moreover, while that 50% bump in the growth rate applies only to evangelicals this finding was only part of my study. In fact, the first part of my paper uses a national Pew Survey taken in November 2001 to see if after controlling for evangelicals, 911, and a host of other confounding factors whether one's employment status affects the likelihood of weekly attendance. I found that being unemployed did increase weekly religious attendance in a statistically significant manner.

What my findings show is that one cannot look at the national average and determine if the recession is affecting religious attendance; one has to look at those folks who have been adversely affected the recession to make that call. Frank Newport and the folks at Gallup seem to miss this point. They only look at the headline number and never dig deeper. Gallup simply is not looking at the right data to answer this question. I have not seen John Green's work from Pew Forum on Religion and Public Life, but I suspect he too is looking at the headline weekly attendance number only. I would encourage Frank Newport, John Green, and other interested observers to take a look at my entire paper here.

What makes this frustrating is that I made this point to the Economist's correspondent who contacted me about this story. I have also contacted the folks at Gallup on this same issue back when this issue came up late last year.

Monday, June 22, 2009

If history of the last switch in reserve currency (from pound sterling to the US dollar) is any guide, the Chinese renminbi can be expected to replace the US dollar as a reserve currency around 2050.

Reisen notes there are a number of problems in making the transition to the Renminbi as a reserve currency. Therefore, he suggests a modified version of the IMF's Special Drawing Rights could serve as the reserve currency. As I discussed here before, it is not clear to me how this move would eliminate the problems creating the global economic imbalances in the first place. Yes, the SDRs would make it easier for countries holding too many dollars to get out of them, but it would not address the structural and policy reasons why some countries run persistent current account surpluses.

With that said, there is an unfortunate irony to the current deflationary threat that can be traced back to 2003. Back then there was another deflationary threat that concerned the Federal Reserve (Fed). As a result, the Fed lowered the federal funds rate to what was at the time an historically low value of 1%. It held this short-term interest rate there for a year before gradually tightening. As we now know, this excessively-loose monetary policy was an important contributor to the buildup of the economic imbalances that eventually led to this economic crisis, including the current deflationary threat. In short, the fear of deflation in 2003 laid seeds for the deflationary threat of 2009.

What makes this an unfortunate irony is that this chain of events did not have to happen. For there was a big difference between the deflationary pressures in 2003 and the ones in 2009. In 2003 the deflationary pressures were driven by rapid productivity gains and were benign in nature. Moreover, nominal spending or aggregate demand was rapidly growing. There simply was no evidence of a malign deflationary threat as there is today and thus, there was no need for the Fed to drop interest rates so low for so long. I have documented these developments in previous posts, but here are a few key graphs that make the case. First, here is the year-on-year productivity growth rate plotted against the ex-post real federal funds rate (click on figure to enlarge):

This pictures shows that Fed was pushing the real federal funds rate into negative territory just as productivity was increasing. The next figure shows final sales to domestic purchasers, a measure of nominal spending in the United States plotted against the federal funds rate. The year 2003 is marked off by the dotted lines (click on figure to enlarge):

No indication here of a collapse in nominal spending in 2003. (There was the weak labor market in 2003, but as I have argued before the slow recovery of employment can most likely be traced to (1) the robust productivity gains and (2) the inordinate substitution of capital for labor given the low interest rates of the time.) What this all means is that the Fed's misreading of the deflationary pressures in 2003 contributed to the creation of deflationary pressures of 2009.

My hope is is that moving forward the Fed and other monetary authorities will be more careful in assessing the sources of and responding to the deflationary pressures.

Tuesday, June 16, 2009

We do need much smaller budget deficits ASAP, but we also need much more stimulus. How do we achieve these two seemingly incompatible goals? With a much more aggressive policy of monetary stimulus we can get faster NGDP growth, and this will reduce fiscal deficits in two ways:

1. The automatic stabilizer part of the deficit will shrink naturally.

I just finished reading Tyler Cowen and Alex Tabarrok's new chapter on the dynamic aggregate demand-aggregate supply model. It was a great read and started me thinking about how the current economic crisis could be viewed in light of the equation of exchange. Interestingly, just as I started thinking along these lines I saw that Nick Rowe had a post praising the equation of exchange. With this inspiration, it seemed only natural for me to go ahead and attempt to frame the current economic crisis in terms of the equation of exchange.

Let me begin by defining the equation of exchange:

MV = PY,

where M is the money supply, V is the velocity or average number of times a unit of money is spent, P is the price level, and Y is real GDP. This identity states that the money supply multiplied by the number of times it is spent must be equal to the current dollar value of the economy. This identity can be further decomposed by noting that the money supply is the product of the monetary base, B, times the money multiplier, m:

M = Bm

or

BmV = PY

With this equation of exchange we can now consider the economic crisis. First, assume that causality typically flows from the left-hand side of the equation to the right-hand side. It is well known what is happening on the right-hand side: both nominal and real GDP are plunging. Here is a figure showing monthly values for both series as well as the trend for 2003-2007. The data comes from Macroeconomic Advisers. (Click on figure to enlarge.)

So what is driving these declines? From the left-hand side of the equation we know it could be (1) change in the monetary base, (2) a change in the money multiplier, a (3) a change in velocity, or (4) some combination of the above. Using the MZM measure of the money supply (see here for why MZM is preferred over M1 and M2), the figure below shows what has happened to the monetary base, the money multiplier, and velocity (Click on figure to enlarge):

Source: Macroeconomic Advisers, St. Louis Federal Reserve

This figure shows that that declines in the money multiplier and velocity have both been pulling down nominal GDP. The decline in the money multiplier reflects (1) the problems in the banking system that have led to a decline in financial intermediation as well as (2) the interest the Fed is paying on excess bank reserves. The decline in the velocity is presumably the result of an increase in real money demand created by the uncertainty surrounding the recession. This figure also shows that the Federal Reserve has been trying to offset these moves by significantly increasing the monetary base. Therefore, the large increase in the monetary base has been far from inflationary; rather it is fighting off the deflationary forces created by by the declines in the money multiplier and velocity.

This figure also has several policy implications. First, remove any obstacles that hinder the money multiplier. That means cleaning up the bank's balance sheets and dropping the Fed's payment of interest on excess reserves. Unfortunately, neither of these seem imminent. Second, adopt policies that will increase velocity. As noted by Alex Tabarrok this is where fiscal policy could potentially play a role. So far, though, it appears from the figure that the current stimulus package is failing to arrest the decline in velocity. (One could ague, though, it is higher than it would otherwise be.) Alternatively, the Fed could do more to increase inflationary expectations which, in turn, would reduce real interest rates, decrease real money demand, and increase velocity. Third, there is no reason yet to pull the plug on the existing expansionary policies. Rather, as Paul Krugman notes (HT Mark Thoma) policymakers need to stay the course until it is clear that the money multiplier and velocity have recovered.

Tuesday, June 9, 2009

Nouriel Roubini tries to sober up all those observers drunken with green shoots tonic:

Those tentative green shoots that we hear so much about these days may well be overrun by yellow weeds even in the medium term, heralding a weak global recovery over the next two years.

First, employment is still falling sharply in the US and other economies...This will be bad news for consumption and the size of bank losses.

Second, this is a crisis of solvency, not just liquidity, but true deleveraging has not really started, because private losses and debts of households, financial institutions, and even corporations are not being reduced, but rather socialized and put on government balance sheets. Lack of deleveraging will limit the ability of banks to lend, households to spend, and firms to invest.

Third, in countries running current-account deficits, consumers need to cut spending and save much more for many years. Shopped out, savings-less, and debt-burdened consumers have been hit by a wealth shock (falling home prices and stock markets), rising debt-service ratios, and falling incomes and employment.

Fourth, the financial system – despite the policy backstop – is severely damaged. Most of the shadow banking system has disappeared, and traditional commercial banks are saddled with trillions of dollars in expected losses on loans and securities while still being seriously undercapitalized. So the credit crunch will not ease quickly.

Sixth, rising government debt ratios will eventually lead to increases in real interest rates that may crowd out private spending and even lead to sovereign refinancing risk.

Seventh, monetization of fiscal deficits is not inflationary in the short run, whereas slack product and labor markets imply massive deflationary forces. But if central banks don’t find a clear exit strategy from policies that double or triple the monetary base, eventually either goods-price inflation or another dangerous asset and credit bubble (or both) will ensue...

Eighth, some emerging-market economies with weaker economic fundamentals may not be able to avoid a severe financial crisis, despite massive IMF support.

Finally, the reduction of global imbalances implies that the current-account deficits of profligate economies (the US and other Anglo-Saxon countries) will narrow the current-account surpluses of over-saving countries (China and other emerging markets, Germany, and Japan). But if domestic demand does not grow fast enough in surplus countries, the resulting lack of global demand relative to supply...will lead to a weaker recovery in global growth, with most economies growing far more slowly than their potential.

So, green shoots of stabilization may be replaced by yellow weeds of stagnation if several medium-term factors constrain the global economy’s ability to return to sustained growth...

Does the new interest rate conundrum have you perplexed? Then try this article by Edward Hugh that delves into the debate between Niall Ferguson and Paul Krugman or take a look at this post by Josh Hendrickson where he argues we should be pleased to see the rising bond yields.

Monday, June 8, 2009

Winters in Michigan are not for the light of heart. Neither are the recessions. Below is a figure showing the year-on-year % change in the coincident indicator for the United States and Michigan from January 1980 to April 2009. (Click on figure to enlarge.)

If the movement of economic activity in Michigan could be made into a roller coaster it would be one thrilling ride!

Jim Hamilton reminds us that a broad look at the data indicates we are far from a robust recovery. Meanwhile, the King Report (via Barry Ritholtz) dashes even the seemingly one sure sign of recovery, the smaller-than-expected decline in NFP employment. It is widely understood that the key to a robust recovery in the U.S. economy is a restoration of household's and bank's balance sheets. How long will that take?

There has been a lot of debate as to how to interpret the rise in long-term interest rates, some of which I have notedhere on this blog. Barry Ritholtz provides a nice summary:

The Bond sell off, which has been sending rates appreciably higher, is being caused by two distinctly different camps. The first are those who believe that the recession has crested and is coming to an end, that global growth will soon resume, and the Fed will therefore be raising rates.This is the Green Shoot crowd.

The other camp sneers at the Green shooters, but does not disagree with their conclusion that the Fed will soon be tightening. This is the inflation camp, and includes the gold bugs, commodity bulls, dollar bears, and hyper-inflationistas.

With Oil up 100% for the year, and the Dollar down nearly 10% from its recent peak, I find this group harder to disagree with. The irony is that each sees the Fed tightening and rates going higher. This is the conundrum the Fed finds itself in . . .[emphasis added]

Note, that even the Fed is reportedly perplexed by this development. For a longer discussion of this debate see Daniel Gross.

Wednesday, June 3, 2009

Martin Wolf has this to say about the rise in long-term interest rates that has the Fed puzzled and others worried:

The jump in bond rates is a desirable normalisation after a panic. Investors rushed into the dollar and government bonds. Now they are rushing out again. Welcome to the giddy world of financial markets.

At the end of December 2008, US 10-year Treasury yields fell to the frighteningly low level of 2.1 per cent from close to 4 per cent in October. Partly as a result of this fall and partly because of a surprising rise in the yield on inflation-protected bonds (Tips), implied expected inflation reached a low of close to zero. The deflation scare had become all too real.

What has happened is a sudden return to normality: after some turmoil, the yield on conventional US government bonds closed at 3.5 per cent last week, while the yield on Tips fell to 1.9 per cent. So expected inflation went to a level in keeping with Federal Reserve objectives, at close to 1.6 per cent. Much the same has happened in the UK, with a rise in expected inflation from a low of 1.3 per cent in March to 2.3 per cent. Fear of deflationary meltdown has gone. Hurrah!

Wolf also responds to the debate among Niall Ferguson, Paul Krugman, and John Taylor.

Tuesday, June 2, 2009

Could this be one of those great turning points in history, when the balance of power tilts decisively away from an established power and towards a rising challenger? It is possible. Financial crises often accelerate the gradual shifting of the geopolitical tectonic plates; they are to history what earthquakes are to geology.

It was inflation that undermined the foundations of Habsburg power and opened the way for the Dutch Republic. It was the disastrous Mississippi Bubble of 1718-19 that fatally weakened ancien régime France, while Britain survived the contemporaneous South Sea Bubble with its fiscal system intact. For most of the nineteenth century, financial crises in the United States had only marginal effects on the City of London. By 1907, however, a Wall Street crash could send a shockwave across the entire British Empire, a harbinger of a new era of American power.

Something similar may be happening as a consequence of the American financial crisis that began nearly two years ago. The flapping of a butterfly's wings may trigger a hurricane in the Home Counties; in much the same way, a crisis in the market for subprime mortgages could signal the waning of US hegemony and the advent of a Chinese century.

Here is an update on the BAA corporate bond yield minus AAA corporate bond yield spread. The overall spread is still elevated at 252 basis points in May 2009, but this is down from the December 2008 peak of 338. (Click on figure to enlarge.)

Monday, June 1, 2009

Late last year James Hamilton referenced the work of Federal Reserve economist Jeremy Nalewai that shows Gross Domestic Income (GDI) does a better job than Gross Domestic Product in finding turning points leading to a recession. Given all the talk about green shoots, I thought I would take a look at real GDI to see how it is performing relative to real GDP:

(Source: BEA table 1.10, 1.1.4, 1.1.1)

This figure shows real GDI experienced a pronounced downturn of -8.2% in 2008:Q4 versus the -6.3 for real GDP. It also shows a sharp bounce back to -3.7% in 2009:Q1 compared to the -5.7% for real GDP. If GDI does as good a job at finding turning points for recoveries as it does recessions then this improvement is a promising development.

Update: I had my quarters labeled incorrectly in the above paragraph and fixed them.

Is Paul Krugman throwing the baby out with the bathwater in his latest column? He argues the fundamental reason we are in this bind is that the financial sector was deregulated in the 1980s, financial innovation took off, and as a result there has been too much borrowing since then. I think many observers would agree there has been a lot of borrowing, but does Krugman really want to inhibit financial innovation just because it makes its easier for individuals to make bad financial decisions? Most inventions and innovations have the potential for creating problems, but instead of outlawing them we try to manage them.

Brad Sesternotes total U.S. borrowing from the rest of the world is down, even though U.S. government borrowing is exploding. That is because households and business are borrowing a lot less. As a result, government borrowing is offsetting the fall in private borrowing. Here is his summary graph (click on figure to enlarge):

As Sester explains, though, once the economy recovers and the private sectors starts borrowing again, government borrowing must come down to keep total U.S. borrowing in line. Observers like John Taylor, Niall Ferguson, John Maudlin, and others, however, are concerned that future government spending will not be reversed once the economy recovers. If so, the real question becomes what is the U.S. Debt-to-GDP number that is too big?

The WSJ's RTE blog is reporting that the IMF will soon be issuing bonds denominated in the IMF's currency called the SDRs. Interestingly, those countries eager to see alternative reserve currency emerge are some of the first to express interest in these bonds:

The International Monetary Fund is putting final touches on its plans to issue its first bonds. Russia has already said it would buy $10 billion of the bonds, which would be priced in the IMF’s quasi-currency, “special drawing rights.” SDRs are a basket of currencies consisting of the euro, yen, pound sterling and U.S. dollar. As of Friday, 1 SDR equals $1.55.

China, Brazil and India also have said they are interested in buying IMF bonds, with China likely to purchase more than $20 billion of instrument. The IMF wants to issue bonds as a way to build up its lending war chest as the global economic nosedive continues.